Another banking crisis looms

Following the release of the FSA's annual "financial risk outlook", I've been seeking the views of bankers and other policymakers on where the main threats to the financial system, and therefore the economy, are likely to come from over the next few years.

Where to start, is the response proffered by most, but beyond the well aired risk of fiscal meltdown, two areas stand out, both of which are discussed at some length in the FSA document. Click here to access the full 88 pages.

One is the risk of a double dip recession, and whether that might trigger a second leg in the property crash, thereby leading to another raft of bad debts coming home to roost on bank balance sheets.

The FSA document reports that UK banks need to find approximately £440bn by 2012 to replace maturing debt. This figure includes more than £300bn of funding provided under the Government's Special Liquidity and Credit Guarantee Schemes. The Governor of the Bank of England, Mervyn King, has made it clear that these schemes will not be rolled over.

As the FSA notes, that's an awful lot of alternative funding that has to be found. But the problem may be much bigger. According to the Bank of England's last Financial Stability Report, published in December, UK banks face a £1trillion funding timebomb. Or to put it another way, that's around £1trillion of term money which matures over the next five years for which alternative funding has to be sought.

One of the features of the banking crisis to date is that banks have become ever more reliant on short term funding. The longer term money just isn't available to them any longer, except at penalty interest rates. UK banks in any case tend to be more dependent on wholesale funding than their overseas counterparts, and around a half of this, according to the Bank of England, is of less than six months maturity. The way things are going, the banking system will soon become wholly dependent on short term funding. As we have discovered, that's potentially highly dangerous, for short term money can easily be withdrawn, creating potential for repeated funding crises.

As the FSA points out, there are a number of potential solutions to this problem. Some of the funding gap will be filled by enhanced saving throughout the economy. Much of the rest of the problem will be magiced away by balance sheet reduction, or to use the jargon, deleverage. That's a problem for the UK economy, and helps explain the present scarcity of credit. Banks don't want to lend because they know they've got a problem funding it. But it does suggest that the funding crunch may not be quite as intractible as some might think.

Even so, a heck of gap will still be left, which absent of calling in loans amounting to a very considerable proportion of GDP, will somehow have to be filled. Securitisation is beginning to come back, and that will plainly help, but it is pretty unlikely ever to return to the heady levels of the boom, and in any case that's not what now risk averse prudential supervisers want. What's more, any revival in securitisation is going to struggle until there is greater clarity on regulatory reform.

Of course, there is another way around the funding problem. There's a price for everything, and for the right price there will always be lenders to the UK banking system. It is just that the price will be a high one, which means that regardless of where the Bank of England sets interest rates, the cost of credit will rise.

If there's a double dip, that price will escalate even further. Here's why. One of the biggest areas of overlending to the UK economy during the boom was property, and particularly commercial property.

There is already a monstrously large heap of unrecognised bad debt relating to commercial property lying on UK bank balance sheets, which banks plan to write off over time. A double dip would both worsen this bad debt position and force more immediate impairments, which would in turn raise fresh doubts about bank solvency and might therefore lead to a fresh funding crisis.

Of course, these are worst case scenarios. But there is a wall of worry to climb out there and an awfully long way to go before we can declare the crisis over.